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Monday, April 7, 2014

The opportunity of a consumption tax – Carmelo Ferlito

APRIL 06, 2014

The recent debate about Budget 2014 drew attention to the proposal to introduce a goods and services tax (GST). As a free market thinker, I am probably supposed to give a negative response to this move. Instead, I will try to highlight the opportunities that such a tax could create.

First, I have to clarify that I am not in favour of increasing taxation in the country; quite the contrary. However, I am in favour of a tax reform that propagates a shift from an income tax toward a consumption tax that is reasonable. Such reform could in fact drive more sustainable economic growth.

A country is on the path to sustainable growth when the intentions of consumers and investors are consistent. A "present-oriented" economy has consumers more oriented to spend than to save and entrepreneurs more focused on short-term, consumption goods investment.

On the contrary, a "future-oriented" economic system is characterised by consumers with the will to save and entrepreneurs investing in long-term projects, precisely because they have access to capital represented by accumulated bank savings.

In countries like Malaysia, we can observe disequilibrium between the consumers' and investors' spending intentions. In fact, the pace of investments is still pretty high, while consumers are far from showing a consistent rate of save. Instead, many purchases are done by credit. Thus, while entrepreneurs are future-oriented, consumers are present-oriented. Figures about household debt are proofs of this.

How is the pace of investment sustained? Not by saving, which means this is not done by the means of sound money, but by credit creation operated through a relaxed credit system, combined with an artificial low interest rate policy imposed by the central bank.

Under these conditions, a crisis would take place. It is simply a matter of time. When inflation rises and the present credit policy is no longer sustainable, many investment projects (in particular Malaysia’s housing sector) would be abandoned. It would be the beginning of the crisis. Western world docet.

How will the consumption tax feature in this scenario? It could have an equilibrating role. In fact, if taxation moves from income to consumption, it will have an "educational role", inducing consumers to spend less and save more.

This means that they will move their preferences from present consumption to future consumption, gradually matching the present investors’ orientations. In fact, an increased saving behaviour will result in more sound, not virtual, resources available for long-term investment projects.

My opinion contrasts with mainstream economic ideas, that stress the importance of consumption for the GDP.

Recently, a BBC journalist commenting on China’s economic progress, expressed the desire for a more consumer and less investment-led GDP growth. This belief, however, is based on the inaccurate assumption that investments can be sustainably driven by virtual money.

Instead, I am more convinced that we should modify the common definition of GDP (consumption + investment + public spending). The present definition does not take into account the positive role played by saving, arguably the only natural and sound source of resources for long-term investments.

From this perspective, a consumption tax, which tends to shift consumer orientation to the future and favours saving, could be the best remedy for more sustainable long-term investments. This could further enrich Malaysia’s economic system.

As mentioned before, the new consumption tax should replace, or partially replace, the present income tax - not simply add to it. A simple sum of new taxes could dramatically frustrate economic activity. A shift of the fiscal burden from income to consumption, instead, could drive better quality growth. – April 6, 2014.

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